Michael Goldman & Associates, L.L.C. - Consulting & CPA Services

Goldman's Critical Support -- Winter 2003

Investigating a Professional Practice for Undisclosed Profits

The forensic review of a professional practice may be triggered by divorce, bankruptcy, fraud, partner disputes, or business valuation. While the basic investigation concepts are the same for professional practices and other types of business, there are particular issues in professional firms that need special attention.

The first step in the investigation is to determine how the practice operates. How does the practice obtain clients or patients, how does it bill and collect for its services, how long is the billing cycle (the time between the start of work and the collection of balances due), and how do transactions typically occur? You can answer these questions by direct observation, interviews with employees, and/or discussions with third parties such as clients, insurance companies, and similar practices.

Where’s the income?

Generally, in larger practices the practitioners are more removed from the actual cash collection process, and have less opportunity to divert or under-report cash collections. Sole practitioners have the greatest ability to hide income, and also the greatest propensity to unintentionally lose money, either to employee theft or due to poor controls that allow clients to get by without paying.

Larger practices will tend to have controls and procedures specifying which staffers receive and handle money, how it is accounted for, and where it is deposited – and by whom. When a small practice operates under the name of the individual (such as “Michael Goldman, CPA”), it is easy for client or patient checks to be deposited or cashed virtually anywhere, not just in a controlled business checking account.

Tax returns of professional practices tend to be unreliable gauges of the practice’s true income. Virtually all professional practices complete their tax returns on a cash basis, which does not accurately match revenues with the costs incurred in generating those revenues.

Accounts receivable, unbilled work, and accounts payable are all items that can be easily manipulated to impact the reported profitability on a cash-basis report. It is easy to slow down collections on accounts receivable to defer cash income. Practices can further defer income by building up an “inventory” of unbilled work that can only be detected by thoroughly comparing time sheets to invoices. While this most commonly is seen in accounting, legal, engineering, and architecture practices, medical practices can build their inventory by slowing down the processing of insurance claims.

Retainer accounts offer further opportunities for income deferral. With the money safely in hand, the professional can defer billing and “collecting” on the retainer for significant periods of time. Lawyers can make this practice even harder to detect with structured settlements. Again, review the time sheets of professionals in the practice and compare them with collections, to determine how much income is still waiting to be recognized.

Revenue reconstruction in a professional practice can be more difficult than in most businesses, because the relationships between income and effort are not always straightforward. Some practices use a multitude of different billing schemes at the same time – hourly charges, value billing, fixed fees, different rates for different procedures, fee compromises, contingent fees, no-charge services, etc. Laws regarding patient confidentiality and client privilege may make it more difficult to analyze revenues than in a typical business.

The type of practice and type of client can provide insights into the likelihood of hidden income:

• Accounting and law firms that serve primarily businesses are less likely to understate income than practices that serve individuals. Highest-risk practices have clients that are likely to pay in cash such as in criminal law practices or high-volume tax return mills for low-income clients.

• Architects and engineers who deal with homeowners and small jobs have a greater opportunity for getting paid in undocumented cash than do practices that focus on large corporations.

• Veterinarians and dentists are more likely than most medical practitioners to have a cash business, because their patients are often uninsured.

• Medical practices that provide procedures where the patients prefer secrecy and may not be covered by insurance, such as plastic surgery, psychiatry, and psychology, are more likely to pay cash.

Inflated expenses and other diversions

On the expenditure side, petty cash can offer an easy vehicle for diverting cash. I have seen professional practices where more money went out through petty cash than to any other type of expense, and there is no accountability for this cash. Other expenses can be aggressively built up by paying invoices quickly, or pre-paying items such as insurance, dues and subscriptions, utility bills, supplies, etc. Erratic trends in these expenses when viewed over a number of years can be a tip-off to the practice of diverting cash for personal expenses.

Most owner-operated businesses leave plenty of opportunity to convert personal expenses into business expenses, and professional practices are certainly no exception. Automobile expenses, travel and entertainment, medical benefits, professional fees, practice development, conventions, telephones, home offices, and dues and subscriptions are all fertile ground for lowering the apparent profitability of a professional practice. Most practices have predictable patterns in their revenue-generating function, and it is important to understand exactly how a practice makes its money to discover these personal expense patterns in a business.

Payroll is usually the largest expense item in a professional practice. Review W-2 forms and quarterly payroll tax returns for irregular activity. Make an effort to ascertain if the entire payroll went to bona-fide employees rather than to relatives, lovers, or ghosts.

Professional firms, especially medical practices, often own assets outside of the practice and rent them back to their business. Review any rent or lease payments to related parties to determine if they are for actual business assets, if they are set at market rates, if there are bargain-purchase options [which would indicate what?], and if they are being consistently paid.

In the past, professional practices could have large amounts of value stored up in unexpected places such as in libraries, databases, or computer software. In most professions the body of knowledge and technology being utilized is changing at an ever-accelerating rate, making these items both more expensive and less enduring than they were in the past. This could mean that the library or software is either much more valuable than would be expected by a quick look, or that if not properly maintained it has diminished in value significantly below its cost. 

Shenanigans

Loans to and from partners or shareholders are usually straightforward transactions, but can leave valuable clues about possible cash flow irregularities (unusually large work in-flows, surprising asset acquisitions, mis-characterized revenues, or significant cash movements with no apparent business purpose) in the practice that should be investigated. Looking at the sources of the funds or the cancelled checks used to pay back the loans can also provide valuable evidence of undisclosed personal accounts.

The existence of multiple entities should raise a flag, especially if they employ separate tax return preparers. It is much easier to make improper transactions look proper when only half shows on each set of books. Often different partners have different feelings about financial shenanigans, so they set up side entities to allow the looser partner to roam while the more conservative partners stay insulated.

Sometimes the most interesting material to review in the investigation of a professional practice is not in the books and records of the practice. Personal records of the individual professionals – financial statements, tax returns, asset registrations and titles, bank statements, brokerage statements, insurance policies, credit card statements, and travel itineraries can often give details of life-styles and real income that the business records would never show. The house that the professional lives in, the car the professional drives, the schools the professional’s children attend, the vacations that they take, etc. can all provide valuable clues to the true income and profitability of the practice.

© Michael Goldman 2003

For more information, please go to www.michaelgoldman.com 

Editorial material in these newsletters is intended to be informative, and should not be construed as advice. For advice on any specific matter, please consult your financial or legal adviser.

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Last modified: September 01, 2010